Value Investing – Page 79

Getting an Initial Read on a Deal

Posted on 1 February 2008 by David Merkel

I wrote at RealMoney.com today:

		David Merkel
		What Would Make More Sense to Me, Redux
		2/1/2008 10:14 AM EST

Nine months ago, I wrote this: Microsoft and Yahoo! are in several different businesses with modest synergies between them. Buried inside such a merger would be (at least):

An Internet advertising company

A web/(other media) content producing company

An operating system/applications software company

A consumer entertainment products company

A web search company, and

A web marketing company.

Going back to our discussion of GE earlier this week, Microsoft does not need more businesses in its portfolio. It needs to focus its activities on what it does best. Same for Yahoo! but their problems are less severe unless they do this merger.

If I were Microsoft, I would accept defeat, and sell all web properties to Yahoo! If I were Yahoo!, I would spin off all content production in a new company to shareholders. You would end up with three focused companies that would be able to hit their markets with precision, in a business where scale matters inside your market, but not across markets. The ending configuration would be:

A software company for everything except the web — Microsoft, which would pay another huge special dividend with the proceeds from the sale.

A web search, advertising and marketing company — Yahoo!, which could focus on competing with Google, and

A web/(other media) content production company (would it make money?)

This to me would be rational, but corporate cash gets spent by self-aggrandizing folks with egos, so this is not likely to happen in the short run. But I think the eventual economic outcome will resemble something like this.

Microsoft has not shown a lot of competence in the areas that Yahoo! has focused on, and because of their long history of growth, I’m not sure they get how to run a company that is transisting into maturity. I would be bearish on the total concept.

The market has awarded an additional $3.7 billion to the combined valuations on Microsoft and Yahoo! off of this news. After some time, that premium should reverse, and it will come out of the valuation of Microsoft. But then, I only play in tech when it is trashed, so what do I know?

Position: none

=-=-=-=-=-=-=-=-=-

By the end of the day, that initial valuation premium of $3.7 billion turned into a deficit of $1.2 billion, and that was against a rising market. I’m not that kind of trader, but some deals make sense, and some don’t. When you find one that doesn’t make sense, and the market value of the package rises, one can short both the acquirer and the target, and wait for rationality to arrive.

That’s not to say that all deals are bad. Value can be added through synergies or improved management, or unlocked through expense savings and more leverage. Microsoft-Yahoo is unlikely to fit any of those descriptions in any major way.

Could Have Been a Lot Worse…

Posted on 1 February 2008 by David Merkel

One month down, eleven to go?? Can we stick our heads out of the foxhole yet?

Personally, I was off just a little in January.? Comparing myself against a bunch of value indexes, which did better than growth indexes in January, I did better than all of them.? We’ll see what the future brings, though, these things can turn on a dime.

So what worked for me?? Arkansas Best, National Atlantic (not out of the woods yet), Charlotte Russe, Gehl, YRC Worldwide, Alliance Data Systems, Reinsurance Group of America, and Honda.

What hurt?? Nam Tai, Gruma, Valero, Deutsche Bank, Royal Bank of Scotland, and Anadarko Petroleum.

Common factors:

Financials with complexity got hurt
Energy was lackluster at best
Industrials, Retail, and Trucking did well
Value took less pain
What got whacked before went up

One final note here.? Look at this graph from Bespoke.? The “sea change” there mirrors my own turn in performance.? What does that tell me?? Perhaps it tells me that in late 2007 there were a lot of hedge funds liquidating positions that value managers liked to own.? After the end of the year, the selling pressure ebbed, and value seekers came in.? At RealMoney today, both Cramer and Marcin were commenting on they could find stuff to buy when the market was down in the morning.? I agreed; I haven’t seen this many good values since 2002.? I’m not counting on anything here, but I think my portfolio has attractive valuations and prospects.? Much as I am not crazy about the macro environment in many ways, I have some confidence that my portfolio should do better than the S&P 500 in 2008.

Full disclosure: long NTE GMK VLO DB APC RBS ABFS NAHC CHIC GEHL YRCW ADS RGA HMC

My Best Relative Value Week in a Long Time

Posted on 26 January 2008 by David Merkel

I’ve worked for years to take the emotions out of my investment processes, with some success.? Where it gets tough is when I am in an absolute and relative drawdown, as I was for most of the second half of 2007.? Nonetheless, I stuck with my disciplines.? This week, a lot of things went right:

Retail
Insurance
Trucking
Energy
Small cap value was the best style

Will this persist?? Who can tell…? I was ahead of the Russell 2000 Value index this week, even though my portfolio is more midcap value in nature.? I’m still wrestling with where to deploy incremental funds.? I’m 2-3 positions light at present, and I know I am already insurance-heavy, with many of my best candidates being insurers, and the rest Irish Banks.? I don’t want to get too heavy in financials… I’m overweight there now.? Ideas are welcome.? Oh, at the end of the day I did make a small purchase:

		David Merkel
		Rebalancing Buy
		1/25/2008 4:02 PM EST

Bought some Gruma, SA into the close. Tortillas and other Mexican foods are not going out of style, even if the Mexican stock markets are having difficulty of late. I’ve had a good week. Hope you did too.

Position: long GMK

The market always has a new way to make a fool out of you, so I am not relying on a change in the financial weather here.? I just keep doing what I do best.

Full disclosure: long GMK

Miscellaneous Musings on Our Manic Markets

Posted on 25 January 2008 by David Merkel

1) I had another good day today, but my body is telling me otherwise.? As I wrote at RealMoney:

		David Merkel
		Two Positive Surprises; Two Things I Don’t Do
		1/24/2008 3:11 PM EST

Two more news bits. I don’t buy for takeovers, but today Bronco Drilling got bought out by Allis-Chalmers Energy. (Now I have three open slots in the portfolio.) I also don’t buy to bet on earnings. But I will ignore earnings if I feel it is time to buy a cheap stock. With yesterday’s purchase of RGA, I did not even know that earnings were coming today. What I did know was that they are the best at life reinsurance, and that it is a constricted field with one big (in coverage written) damaged competitor, Scottish Re. So, today’s good earnings are a surprise, but the quality of RGA is not.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Scottish Re to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: long RGA BRNC

2)? There’s a lot of commentary going around on the Financial Guarantors and bailouts, whether to profit-seeking individuals like Wilbur Ross, or a consortium of investment banks who will not do so well without them.? For a good summary of what will make a consortium bailout of the industry as a whole tough, read this piece at Naked Capitalism.? I will say that Sean Egan’s estimate of $200 billion is too high (maybe he is talking his book).? Just on a back of the envelope basis, the whole FG industry earned about $2 billion per year.? If they needed $200 billion more capital to be solvent, their pricing would have to expand about 5-10 times to allow them to earn an acceptable ROE.? No one would pay that.? So, if the $200 billion is right, it is just another way of saying that the FG industry should not exist.? (Well, the Bible warns us of the dangers of being a third-party guarantor…)

Then again, there are many risks that Wall Street takes on where the probability of ruin is high enough to happen at least once in a lifetime, but adequate capital is not held because protecting against the meltdown scenario would make the return on equity unacceptable.? The risk managers bow to pressure so that the businesses can make money, and hope that the markets will stay stable.

3) There’s been even more musing about the Fed 75 basis point cut, with a hint of more to come.? No surprise that I agree with Caroline Baum that the Greenspan Put is alive and well, or with Tony Crescenzi that we could call it the Bernanke Pacifier.? But Bill Gross leaves me cold here.? He and Paul McCulley consistently argued against raising rates during the recent up cycle, and in the prior down cycle cheered the lowering of the Fed funds rate down to 1%.? These policies, which overstimulated housing, helped lead to the situation that Mr. Gross now laments.

I also think that David Wessel and many others let the Fed off too easily on their misforecasting. ? Who has more Ph.D. economists than they do?? I’m not saying that the Fed should read my writings, but there is a significant body of opinion in the financial blogosphere that saw this coming.? Also, they basked in their aura of invincibility when it suited them, particularly in the Greenspan era.

As I commented last night, Bernanke is a bright guy who will not let his name go down in the history books as the guy who allowed Great Depression #2 to emerge.? So as? the bubble bursts, the Fed eases aggressively.? Even Paul Krugman points to the writings of Bernanke on the topic.

One last note on the Fed: Eddy Elfenbein points out the basic mandate of the Fed.? I’m not sure why he cites this, but it is not a full statement of the Fed mandate, unless one interprets it to mean that the Fed has to promote the continuing growth of the credit markets (I hate that thought).? Since the Fed is a regulator of banking solvency, and must be, because money and credit are similar, the Fed also has a mandate to preserve the banking system under its purview.? That’s difficult to do without overseeing the capital markets, post Glass-Steagall.? Unfortunately, that is what creates at least the appearance of the “Greenspan Put.”? And now the market relies on its existence.

4)? But maybe the Fed overreacted to equity markets getting slammed by SocGen exiting a bunch of rogue trades.? Perhaps it’s not all that much different than 2002, when the European banks and insurers put in the bottom of the US equity markets but being forced to sell by their regulators. If so, maybe the current lift in the markets will persist.
As for SocGen, leaving aside their chaotic conference call, I would simply point out that it is a pretty colossal failure of risk control to allow anyone that much power inside their firm.? Risk control begins with personnel control, starting with separating the profit and accounting functions.? Second, the larger the amounts of money in play, the greater the scrutiny should be from internal audit, external audit, and management.? I have experienced these audits in my life, and it is a normal part of good business.

Because of that, I fault SocGen management most of all.? For something that large, if they didn’t put the controls in place, then the CEO, CFO, division head, etc. should resign.? There is no excuse for not having proper controls in place for an error that large.

That’s all for the evening.? I am way behind on my e-mail, so if you are waiting on me, I have not given up on responding to you.

Full disclosure: long RGA BRNC

What a Day!

Posted on 24 January 200824 January 2008 by David Merkel

I didn’t feel well today, but my broad market portfolio did better than me. I probably could not have picked a worse day to do my reshaping, but here are the results:

Sales:

Aspen Holdings
Flagstone Reinsurance
Redwood Trust
Mylan Labs
Lafarge SA

Purchases:

Reinsurance Group of America (old friend, cheap price)
Honda Motors

Rebalancing Buys:

Valero
ConocoPhillips
Vishay Intertechnology

Rebalancing Sale:

Deerfield Capital

I’m not done. My moves today raised cash from 5% to 10%, and trimmed positions from 36 to 33. I have room for two more ideas, and am working on where to place cash. My timing of buys and sells today was good — not that that is a key competency of mine by any means.

Aside from the sale of the reinsurers, which were just cheap placeholders, the other positions were not as relatively cheap as they once were. RGA and Honda are quality companies selling at bargain prices. If I had more names like those, I would buy them all day long.

Away from my broad market portfolio, I raised my equity exposure in my mutual funds fractionally today. Time to rebalance.

PS — I can’t remember another day quite like this, where the late negative to positive move was so pronounced.

Full disclosure: long DFR RGA HMC VLO COP VSH

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A Bonus from MoneySense Magazine

Posted on 23 January 200820 June 2017 by David Merkel

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.? In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.? Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.? Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.? It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.? This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.? That said, valuations are more compelling than they were, especially compared to Treasuries.? Compared to BBB corporate yields, they are still attractive.? I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

Insurance Thoughts

Posted on 19 January 200820 January 2008 by David Merkel

I am known for my views on insurance stocks, and I wrote about those views at RealMoney yesterday:

		David Merkel
		Buy Insurance Stocks. Really.
		1/18/2008 12:04 PM EST

Bouncing off Adam?s comments on the XLF, the insurers in the index are getting drubbed, and in my opinion, for little good reason. On an earnings basis, many of them are the cheapest I have seen maybe ever, and while some of their earnings prospects will be diminished by the fall in the market, and difficulties in the bond market, in general, the asset side of their balance sheets are in good shape. So, if you are looking for ideas, here are a few I am looking at: MetLife, Hartford, Travelers, Lincoln National, ACE, Chubb, Principal and XL. Hopefully this will do as well as my PartnerRe trade last August.

Position: Long LNC

I would add to that list SFG and DFG. After some thought, I acted:

		David Merkel
		Bought Some Hartford, Added to Lincoln National
		1/18/2008 12:45 PM EST

Lincoln National was a rebalancing buy, Hartford is a new position. Both are quality competitors with good balance sheets. The only possible drawback is in a protracted decline, earnings from variable products could suffer.

Position: long HIG LNC

Then, at the end of the day, I added:

		David Merkel
		The Dike Has Sprung a Leak
		1/18/2008 4:30 PM EST

Fitch downgrades Ambac to AA from AAA. Stock has a temporary rally. Is this a great country or what? Because of the social dynamic of the rating agencies, and the existence of one downgrade, the dike has been breached, and I would expect more downgrades.

Hey, maybe it?s time for the financing of last resort: Ambac could issue a convertible surplus note. Maybe even sell it privately to Buffett, who could own 30% of the company if things turn around. He won?t delta-hedge common against it. They might even be able to get away with a coupon below 15%. Package it with a reinsurance agreement, and the NY State commissioner smiles on it.

Okay, I went overboard there, but there was no reason for Ambac to have its short-lived rally. That?s probably why it didn?t stick.

Position: none

My last note was half-whimsical and half-serious. Buffett likes convertibles, particularly if they offer attractive optionality at the right price. The question is how big the problems are at Ambac relative to their small capital base.

Now, after the downgrade of Ambac, Fitch moved to downgrade Ambac-guaranteed bonds. This is serious stuff. Moody?s and S&P will also likely move on Ambac, and MBIA, FGIC, SCA, and more. Channel Re is toast, and PartnerRe and Ren Re have written off their stakes in them (what of MBIA?).? ACA Capital is dead, or nearly so, facing a midnight deadline for forebearance from their counterparties.

I should also add that there are reinsurance issues among the financial guarantee companies have reinsurance issues.? I mentioned Channel Re, which mainly provided insurance to MBIA.? MBIA and Ambac, from what I remember, mutually reinsure about 10% of each other’s liabilities.? Beyond that, you have poor RAM Re:?

RAM Re attempts to absorb a quote share of the liabilities of the primary financial guarantors.? I met their management team during their IPO.? They seemed to be good people, and talented managers.? But having a quota share of the seven soon-to-be-formerly-AAA guarantors is a ticket to not being AAA oneself.? They face risks of insolvency of primary writers, which could lead to their own insolvency.

What I am trying to convey here, is that stress at one guarantor could have ripple effects at other guarantors.? The least affected would be Assured Guaranty, FSA (a Dexia subsidiary), and Berky (of course).

As for the recent Barron’s article on MBIA, I would only say that it all depends on structured finance losses.? If losses on CDOs are severe, MBIA could be a sell even at these levels.

These are unusual times, and it pays for investors to avoid for the most part the financial guarantee space (mortgage and title too).? Other insurers (life, health, P&C) are likely better than other financials, and generally cheap; I own a bunch of them.

Full disclosure: long LNC HIG

Tickers mentioned: SCA RAMR AGO ACAH MBI ABK BRK/A BRK/B HIG LNC MET PFG DFG SFG CB TRV MET ACE XL

Shrink Positions or Position Sizes?

Posted on 18 January 2008 by David Merkel

In the past, when I hit a major downdraft in the market, I find myself debating whether I should reduce the number of positions in my portfolio, or shrink the mean position size.? The latter is the easier choice, which is why I take the former, and shrink the number of positions, forcing me to eliminate marginal names in the portfolio.

Today I added to Nam Tai Electronics and Deerfield Capital, bringing my over all cash position down to 8%.? As I work through my reshaping, I expect my cash level to decline further, but I would probably liquidate one of my 35 stocks without replacement to help fund the reshaping and rebalancing.

At times like now, this is a process that hurts, and sometime next week, I will announce my portfolio shifts.? That said, the portfolio has held up better versus the market recently.

Full disclosure: long NTE DFR

An Anomalous View of Stock Investing

Posted on 17 January 2008 by David Merkel

I was impressed with what Charles Kirk had to say regarding AAII and Stock Screening.? I’m a lifetime member of AAII, and I’ve used their stock screening software for years, long before I was a professional.? I was also impressed to note in the recent issue that two of my four buys in the fourth quarter were buys in the shadow stock portfolio, which has done very well over the years.

Back to Charles Kirk, if I can quote a small part of his piece:

When looking over the information, among many things I noticed include the fact that 7 stock screens have posted gains for every year over the past 10 years. Screens with this amazing consistency include Graham’s Defensive Investor, Price-To-Sales, Zweig, PEG With Est Growth, PEG With Hist Growth, and two of O’Shaughnessy’s screens – Small Cap Growth & Value and Growth. Few screening strategies can produce gains year after year as these have and there’s something to be learned from them.

Looking through and comparing the criteria between all of these screens, in essence they were seeking four simple things: 1) growing earnings per share over various time frames, 2) strong sales growth, 3) an attractive valuation (often using price-to-sales), and 4) relative strength.

Though I may quibble with O’Shaughnessy’s methodology, this is consistent with what he found in his book What Works on Wall Street.?? That said, though I am more agnostic about market capitalization, as I looked across the shadow stock portfolio, which is a small cap deep value portfolio, it confirmed to me that there are a lot of cheap stocks to buy in this environment.? There are good gains to be had in the future, even if past performance has suffered.

Now to approach it from a different angle.? I mentioned how much I like the CXO Advisory blog.?? One page to visit is the Big Ideas page, if you like academic finance papers.? I want to give you my short synopsis of what seems to work:

Cheap valuation, particularly low price-to-book (though I like cheap price-to-everything… book, earnings, sales, dividends, EBITDA)
Price momentum
Low accrual accounting entries as a fraction of earnings or assets
Piotroski’s accounting criteria
Low net stock issuance
Positive earnings surprises
Low historical return volatility
Illiquidity, which is a proxy for size and neglect

There are other prizes on that page, including mean-reversion, an improved Fed Model, Dollar-weighted vs. Time-weighted returns, limitations on academic financial research, demography, etc.

I would simply tell the fundamental investors in my audience to think about these issues.? Let me summarize them one more time:

Look for a cheap valuation.
Look for mean reversion, but don’t try to catch a falling knife.
Grab positive price momentum and earnings surprises.
Look for sound accounting, and management that is loath to dilute shareholders.
Avoid volatile stocks
Look for neglected stocks

That’s my my quick summary for what seems to work in stock selection.? I invite commentary on this.? I downloaded a lot of the papers cited, and will be reading them over the next few months.

Relying on the Kindness of Strangers as an Investment Strategy

Posted on 15 January 200815 January 2008 by David Merkel

In 2002, when many credits were troubled, I would look at some of troubled positions that we held and do a recovery analysis, to see what we might get if the company filed for insolvency. Often in that process, I would find that investors elsewhere in the capital structure had different motivations than we did. The bank might prefer to liquidate the stinker, while the bondholders, in a more junior position, would prefer it kept as a going concern. Or, the equity investors that have control of the company might pursue a unprofitable strategy that encumbers the assets of the firm, leaving the bondholders with a less valuable entity for their debt claims. Or, the company could issue secured debt, effectively subordinating bondholders, while providing cash that could be used to buy back stock. Another case is when you have a valuable company with a liquidity problem. The banks will be willing to lend against that trapped value so that the company can repay bondholders, right? Right?! (Sigh.) In most of these situations, a bond investor finds that he is implicitly relying on the kindness of strangers. That is rarely a good place to be. 🙁

Now, a few judicious debt covenants could partially level the playing field, but with investment grade bonds those are rare. (Covenants work a lot better than fraudulent conveyance lawsuits, etc….) My main point here is that it pays to analyze situations in advance to understand when your bargaining power is weak. Risk control is best done on the front end, not the back end. Equity/Management will always hold the “capital structure” option to some degree, and unsecured lenders will always have a weak hand there.

So when I read this article about ladies in Baltimore losing their homes because they didn’t do enough scrutiny of the mortgage documents, partly because they were deceived by people who were seemingly experts, who said that they would be able to refinance the rate when the reset date hit, I thought about relying on the kindness of strangers again. It would be one thing if guaranteed refinance terms were offered at the initial refinancing, but absent that, credit conditions are fickle, and it can be a short interval between loose credit and tight credit. Relying on the ability to refinance a debt is always risky.

Today, consumer credit terms are tight. A year ago, they were moderately loose. Two years ago, terms were stupid loose. Who knows, later this year, terms could become stupid tight, where even good quality borrowers with adequate security can’t get credit.

Again, in investing, and even in personal finance, strive to understand your bargaining position. Do you hold the options? If it’s not you or those with you in your position, then others hold the options to control the assets. Usually those are held by the equityholders (or management, who sometimes act in their own interest, not that of the shareholders), and senior or secured debtholders. Those with weak positions, like preferred stockholders, unsecured and junior debtholders must be compensated for the weak position with extra yield or covenant protections.

The same analysis applies to structured securities, whether the credit enhancement comes from a guarantor or a senior-subordinate structure. In the good times, the equity controls the deal. In the really bad times, control often slides to those who are most senior in the capital structure.

On a personal level, a house is controlled by the owner if he can stay current on the payments (if any). Absent that, the bank controls the situation, subject to the rights of other claimants (the taxman, home equity lenders, mortgage insurers, etc.)

If strangers are kind to you, that is a good thing. Be grateful for a society that encourages that kindness. But don’t rely on it in investing or personal finance.

PS — sometimes even a good analysis of your rights and options can go awry. The KMart bankruptcy was a good example of that, where KMart had assets worth more than their liabilities, and could have gotten financing to continue. But a bankruptcy judge allowed their petition, and they were able to give creditors and lessors the short end of the stick. Those that controlled KMart post-bankruptcy made out handsomely. It would be difficult to repeat that aspect of the success.

Thus, you might look at this good article on Sears Holdings (successor name for KMart) in a slightly different light. The financial engineering gains can’t be repeated. It now must make its money as a retailer. As the article gently points out, being a good investor and a good retailer don’t naturally go together.

Bringing this back to topic, does management of Sears act in the best interests of shareholders? Management has the incentives to do so, but sometimes the intellectual gratification of the CEO can get in the way of making good business decisions. Management has control, the outside passive minority investors do not. Their only options are to ride on the Sears bus, or get off. If an investor doesn’t think the management of Sears is doing it right, he would be foolish to trust them with his money.